Barro on the Ricardian Equivalence Theorem

Author(s): James M. Buchanan

Source: Journal of Political Economy, Vol. 84, No. 2 (Apr., 1976), pp. 337-342
Published by: The University of Chicago Press
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Barro on the Ricardian Equivalence
Theorem
James M. Buchanan
VirginiaPolytechnicInstituteand State University

Is public debt issue equivalent to taxation? This is an age-old question in

public finance theory. David Ricardo presented the case for the affirma-
tive.1 Professor Robert J. Barro reexamines the question in his recent
paper (1974) without, however, making reference to Ricardo or other
early contributors. Although his discussion is carefully qualified to allow
for exceptions under specified conditions, the thrust of Barro's argument
supports the Ricardian theorem to the effect that taxation and public
debt issue exert basically equivalent effects.
Barro's central emphasis is on demonstrating that, under reasonable
conditions which involve overlapping generations of persons with finite
lives, taxpayers will capitalize the future obligations that public debt
issue embodies. To the extent that this capitalization occurs, government
bonds do not add to the perceived net wealth in the economy. From this
Barro infers that the substitution of debt for tax finance will exert no
expansionary effect on total spending. There are two questions here. Are
the future tax liabilities fully capitalized? And, even if they are, does this
necessarily imply that the fiscal policy shift exerts no effect on total
spending? To establish the second result, it is necessary to examine the
differential impacts of taxation and debt issue, quite apart from the
question of the capitalization of future taxes. Barro wholly neglects this
necessary part of any comparative analysis of the two fiscal instruments,
and, because of this neglect, his conclusion is not nearly so relevant for
policy as it seems to be. This neglect may stem from Barro's failure to
specify properly the inclusive set of transactions that debt issue represents.

I am indebted to my colleagues Gordon Tullock, Nicolaus Tideman, and Richard

Wagner for helpful comments.
I The basic Ricardian discussion is contained in Ricardo (1951, vol. 1, pp. 244-49) and
"Funding System" (vol. 4, pp. 149-200). Antonio De Viti De Marco elaborated the
Ricardian thesis in a somewhat modified setting. His analysis was first developed in De
Viti De Marco (1893). Essentially the same analysis appears in De Viti De Marco (1936,
bk. 5, chap. 1, pp. 377-98). For my own summary discussions, see Buchanan (1958,
pp. 43-44, 114-22).
[Journal of Political Economy, 1976, vol. 84, no. 2]
? 1976 by The University of Chicago. All rights reserved.

337

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338 JOURNAL OF POLITICAL ECONOMY

After constructing his overlapping-generations model with no govern-

ment sector, Barro then superimposes an issue of public debt without off-
setting or compensating changes. He states, "Suppose now that the gov-
ernment issues an amount of debt, B, which can be thought of as taking
the form of one-period, real-valued bonds.... It can be assumed, for
simplicity, that the government bond issue takes the form of a helicopter
drop to currently old (generation 1) households" (p. 1101). We are
immediately prompted to inquire why any government would undertake
such an activity. If the purpose is to increase total spending in the
economy, this might be done much more readily by the straightforward
issue of money, which does not involve future payment obligations. Or,
if the purpose is to finance public spending without current taxation or
money creation, bonds must be sold in the private capital market, and
persons who purchase these bonds must draw down private investments
or reduce private consumption. Under this condition, it is impossible that
"the increase in B implies a one-to-one increase in the asset supply. .
(p. 1103).
There are two alternative interpretations of Barro's seemingly bizarre
model of bond issue. The first and more constructive interpretation sug-
gests that Barro introduces the model only because of his concentrated
interest on the wealth effect of debt issue within the strictly Ricardian or
differential-incidence framework. The second interpretation suggests that
Barro's analysis applies only when governments do, in fact, incur future
payment obligations without securing command over funds in the initial
period, a setting which does not apply to public debt as ordinarily con-
ceived but which may apply to the operation of the social security system
in the United States.
These quite separate interpretations may be discussed briefly in turn.
Barro directly follows the first statement cited above with the following:
"Equivalently, it could be assumed that the bonds were sold on a com-
petitive capital market, with the proceeds of this sale used to effect a
lump-sum transfer to generation 1 households" (p. 1101). Superficially,
the two operations are not at all equivalent. If, however, the bonds drop-
ped from the helicopter are marketable, those who get them may, as
desired, convert them into currency. The net effects are the same as the
government's sale of bonds to voluntary purchasers along with the lump-
sum transfer of the proceeds to the same persons who would have received
the bonds in the first model. In either case, the government bonds will
replace private bonds or other assets, and the net-wealth effects of this
substitution must be considered along with the wealth effects embodied
in the capitalization of future tax liabilities. Why might Barro have felt
that he could neglect the first of these considerations? He could have done
so if his interest is exclusively on determining the differential effects of

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COMMUNICATIONS 339
(a)

Taxation
Assets Liabilities

Public assets (?)

Private assets (-)

(b)

Debt Issue
Assets Liabilities

Public assets (+)

Private assets (-)

Government Present value

bonds (+) of tax liabilities (+)

FIG. 1

debt and tax financing, and he is willing to make the severely restrictive
assumption that the source for the ultimate purchase of the government
bonds is identical to the source from which the alternative taxes would
be drawn.
This may be clarified by the following simple t-account comparison.
Under the tax alternative, the t-account adjustments appear as in figure
la. Under either of the debt-issue alternatives, the final t-account adjust-
ments are as shown in figure l b. If we are interested only in comparing the
differential effects of tax and debt finance for a given level of spending,
and if we are willing to make the heroic assumption that the direct
impact of these two fiscal instruments is identical, then the part of figure
lb below the dotted line represents the net difference between the two
combined fiscal operations.
In this interpretation, Barro is simply not concerned either with the
independent effects of debt-financed spending on net wealth or with the
effects of public debt issue in a modified differential-incidence framework.
Does the financing of public spending by genuine public debt increase
aggregate demand in the economy? This is a meaningful and relevant
question that has been more widely discussed than the one which Barro
analyzes. In terms of figure 1, this question requires us to look at the

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340 JOURNAL OF POLITICAL ECONOMY

adjustments in figure lb only, without regard to any comparison with 1a.

Provided that we do not go beyond the simple t-accounts, the net-wealth
effect of debt financing of public outlay seems to depend on the degree
to which future taxes are discounted. But this neglects the possible effects
of the sale of bonds on displaced private borrowers. To the extent that
these borrowers, those who would have secured the funds had not the
government done so, would have applied the same discount factor to the
future payment obligations as that applied by the public borrowers (the
taxpayers), net wealth will not be modified regardless of the degree of
capitalization of future taxes. It seems reasonable to suggest that perceived
net wealth, as relevant for spending behavior, increases with increases in
either private or public debt. But there are offsetting changes, and the
direction of net effect depends on the differences.2
Perhaps the most familiar setting is one that compares the effects of
debt financing with explicit money creation for a given increment in
public outlay. This, too, is a differential-incidence model but one that is
quite separate from the Ricardo-Barro model. The analysis here requires
all of the considerations noted above with respect to independent debt
issue but has the advantage of emphasizing the specific deflationary impact
of debt sales quite apart from the question of future tax capitalization.3
This latter aspect assumes primary importance, of course, when the
principal objective for fiscal policy is to generate an expansion in aggregate
spending.
Barro's analysis may be interpreted in a second and more restrictive
way that takes his explicit model for debt issue at face value and makes
no attempt to generalize it toward meeting the expressed purpose of the
paper. In this view, Barro analyzes the issue of debt by a government
which does not secure funds in the initial period and which does not allow
its debt obligations to be resold in markets. Something analytically
analogous to this sort of operation may take place when legislation is
enacted which commits the government to pay old-age pensions without
at the same time fully financing such obligations with current levies of
taxes. Barro does, in fact, refer to the applicability of his analysis to social
security financing, and he may have been led to generalize too readily
from this somewhat singular example. In this setting, the aggregate
economic effects depend strictly on the relative discounting of future
benefits on the one hand and future taxes on the other.

2 In a strict accounting sense, future obligations that are implicit in any debt issue,
public or private, may be fully capitalized, while at the same time behavior may reflect
the rational intent of borrowers to accelerate spending. In this context, a lending-borrow-
ing transaction must affect aggregate spending quite apart from the absence of change
in measured net wealth. See R. N. McKean (1951, particularly p. 75).
3 See Musgrave (1959, p. 538). For particular emphasis on the deflationary impact of

debt issue see Rolph (1957).

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COMMUNICATIONS 34I

To this point my criticism of Barro's paper has been confined to the

ambiguities in his setting for public debt issue along with the possible
incompleteness of his analysis. I have not challenged his basic conclusion
that future taxes will tend to be fully discounted save under the exceptions
that he notes. Nonetheless, this conclusion may be questioned on empirical
grounds. What evidence might be adduced to suggest that individuals do
not, in fact, modify their behavior fully to adjust for the present values of
the future tax obligations that public debt issue implies?
Consider, first, the social security system which, as indicated, fits more
closely with the narrow interpretation of Barro's results. One implication
of his analysis would be that the social security system as it has operated
should not have modified the rate of private saving in the economy. This
runs counter to the result that has been observed by Martin Feldstein,
who estimates that the rate of private saving has been reduced by some
38 percent.4 Additional evidence may be indirectly available from the
historical record if the basic public choice paradigm is accepted. If
politicians are ultimately responsive to the desires of their constituents,
we may infer something about constituents' evaluations by observing
the behavior of politicians. The 40-year history of social security financing
yields ample evidence that politicians are extremely reluctant to adopt
anything which smacks of full funding for the system. Under the Barro
hypothesis, there should be roughly indifferent public reactions to a fully
funded and to an unfunded pension system.
If we shift to the more general model, governments should be roughly
indifferent as between financing current outlays from taxation and from
genuine debt issue. There should be no effect of debt-financed deficits
on aggregate spending. Direct testing of this hypothesis is difficult because
of the fact that budget deficits are normally financed by some combination
of genuine debt issue and money creation.5 Again, however, the behavior
of legislators seems to offer indirect evidence against the capitalization
hypothesis. Can anyone in the post-Keynesian world of 1975 seriously
question the proclivity of politicians to expand public debt in preference
to tax increases? At the state-local level, where the money-creation
powers do not exist, why should we observe constitutional constraints on
public debts?6 With public as with private finance, the very creation of
debt suggests that borrowers desire to accelerate spending.

4 See Feldstein (1974). It should be noted that, even with full lifetime discounting of
future taxes, a life-cycle model of utility maximization would produce a negative effect
on private saving under a pay-as-we-go public pension system. But, of course, the life-
cycle model itself implies that debt financing necessarily differs from tax financing to
the extent that debt is not retired within a generation.
Kochin (1974) attempted to estimate empirically the impact of deficit spending on
private consumption. His conclusions tend to support the capitalization view.
6 Admittedly, the out-migration prospect for citizens in local jurisdictions offers an
offsetting influence to full discounting.

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342 JOURNAL OF POLITICAL ECONOMY

References
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Feldstein, Martin. "Social Security, Induced Retirement, and Aggregate Capital
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Kochin, Lewis. "Are Future Taxes Anticipated by Consumers?" J. Money,
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McKean, R. N. "Liquidity and a National Balance Sheet." J.P.E. 57, no. 6
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Musgrave, R. A. The Theory of Public Finance. New York: McGraw-Hill, 1959.
Ricardo, David. Principles of Political Economyand Taxation, Works and Correspondence.
Edited by Piero Straffa. Cambridge: Cambridge Univ. Press, 1951.
Rolph, Earl. "Principles of Debt Management." A.E.R. 47 (June 1957): 302-20.

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